US Treasury the winner with North American shale boom

Americas shale boom is providing an unintended benefit
to US government bonds.

With the US economy relying less on oil and gas imports than
at any time in two decades, energy expenses for US citizens
have fallen and cut into inflation more than any other living
cost in the past year, according to data compiled by the US
Department of Labor (DOL). Economists say consumer prices
will rise less than 2% for a second straight year in 2014,
the first time thats happened during an expansion in a half-century.

Slowing inflation, which increases the purchasing power of
fixed-rate payments, would give support to Treasuries after
the Federal Reserves plan to curtail its unprecedented
bond buying ignited their first annual losses since 2009.
Ten-year notes yielded 1.76% last month after deducting
inflation, close to the highest since 2011. Spending fewer
dollars on foreign oil also means that any gain in crude
prices no longer leads to a weaker greenback, upending a
decade-long relationship that may strengthen the value of US
assets.

Real Yields

Energy prices have become disinflationary in the US as the
nation comes closer to attaining energy independence, which
has been bolstered by the proliferation of hydraulic
fracturing of the nations shale deposits.

While a DOL report last week showed that fuel helped lift
consumer prices 0.3% in December, the most in six months,
energy expenses for all of 2013 still decreased.

The costs of gasoline and fuel oil, which account for about
10% of the US consumer price index, fell 0.8% last year, the
biggest drag on annual inflation of 1.48%. Oil prices will
fall 5.5% in 2014, according to an annual forecast from the
Department of Energy (DOE), which will help limit the
increase in living expenses to 1.7% this year.

The last time the cost of living in the US rose less than 2%
for two straight years during an expansion was in 1964 and 1965,
DOL data show.

Real yields on the benchmark 10-year note climbed to within
0.1 percentage point of highest level in 34 months on Dec.
27, according to data compiled by Bloomberg. The greater the
real yield, the more debt investors are insulated from a loss
of purchasing power as the dollars needed to buy the same
amount of goods and services increase.

The 10-year note yielded 1.36 percentage points more than the
rate of inflation today, higher than the average of 1.07
percentage points in the past decade, data compiled by
Bloomberg show. As recently as March, real yields were
negative.

Thats why we have Treasury exposure,
McIntyre said in a telephone interview from Philadelphia.

Energy Independence

Treasuries, which posted just their fourth annual decline
since 1978 as an improving US economy strengthened the
Feds case to taper its stimulus, are now off to the
best start in five years. The $8.3 trillion of U.S.
government debt from 1-year notes to 30-year bonds included
in the Bank of America Merrill Lynch US Treasury Index has
returned 0.8% in January after losing 3.4% last year.

Yields on the 10-year note were at 2.86% this week after
falling for a third week to 2.82% in the five days through
through Jan. 17. The price of the 2.75 percent bond due in
November 2023 was 99 3/32.

Demand for fracking, a method used to fracture underground
oil- and gas-bearing rock formations such as the Bakken shale
in North Dakota and the Eagle Ford in Texas by injecting a
mixture of water, sand and chemicals to create cracks and
release the fuel, increased as rising oil prices in the past
decade made it more affordable to explore on land than under
water.

The US is producing so much oil from fracking that the DOE
estimates output will surge this year to the highest since
1986, helping to cap energy costs domestically.

More Reliable

Government restrictions on crude exports also mean increasing
production helps insulate the worlds largest
oil-consuming nation from price shocks stemming from
fluctuations in foreign supplies.

West Texas Intermediate (WTI) crude, the US benchmark grade,
will decline to $93/bbl this year from $98.42/bbl at the end
of 2013, based on the DOEs projection. As recently as July,
analysts in a Bloomberg survey estimated that the price of
oil would increase to $103/bbl by the end of 2014.

Crude oil futures have already fallen 4.5% this year, with
WTI futures ending at $94.37/bbl last week. Thats
$12.11 less than a barrel of Brent crude, the European benchmark grade. The WTI
discount is three times as wide as the average of $4.02 over
the past decade.

The more that we produce, the more reliable our source
is, and thats certainly going to help keep a lid on
prices, James Sarni, senior managing partner at Payden
& Rygel, which manages $85 billion, said by telephone
from Los Angeles. Inflation will be lower for longer
than people think and whatever rate rise we do see will be
less than people think.

Structural Inflation

Yields on 10-year Treasuries will climb to 3.45% by the end
of 2014, according to the median forecast of 69 economists in
a Bloomberg survey.

A stronger US economy will spur consumer demand that lifts
prices more consistently as wages increase, which may offset
declines in energy costs and erode the appeal of Treasuries,
according to Ira Jersey, a New York-based interest-rate
strategist at Credit Suisse Group AG.

Wage inflation tends to be more structural and tends to
last longer, Jersey of Credit Suisse, one of 21 primary
dealers that are obliged to bid at US government debt
auctions, said in a Jan. 14 telephone interview.

The worlds largest economy will expand 2.8% this year
and accelerate to a 3% pace in 2015, which would be the
fastest in a decade, based on economists surveyed by
Bloomberg.

OPEC Dollars

The Fed, which has flooded the economy with more than $3
trillion to stimulate growth, will cut monthly purchases of
Treasuries and mortgage-backed securities to $75 billion from
$85 billion this month. The bank will then reduce buying by
$10 billion in each of the next six meetings before ending
its stimulus program in December, according to 42 economists
surveyed by Bloomberg in January.

Higher US oil output is also leaving the Organization of
Petroleum Exporting Countries (OPEC) with fewer dollars to
invest in Treasuries. OPEC nations are on track to hold fewer
Treasuries at the end of 2013 than the start, which would be
the first annual decline since 2003. OPEC members held $236.2
billion of Treasuries at the end of November, 9.8% less than
at the end of 2012, government data show.

Nevertheless, spending fewer dollars abroad to buy crude oil
means the US currency is no longer depreciating as demand for
crude rises, which may ultimately help preserve the value of
Treasuries for foreign creditors. They hold almost half of
the nations $11.8 trillion in marketable debt
obligations as of November, with China and Japan together
owning $2.5 trillion.

Feedback Loop

Over the past decade, the dollar has usually weakened
whenever crude rose. That relationship broke down last month,
according to data compiled by Bloomberg. The 120-day
correlation between the two assets, which has averaged minus
0.3 over the past 10 years, turned positive in December
before climbing to 0.033, which was the highest since
February 2003, data show.

A reading of minus 1 means two securities always move in
opposite directions, 0 means their moves arent related
at all and 1 indicates that they always move in the same
direction.

In July 2008, when oil reached a record $145.29/bbl, the
dollar traded at $1.57 per euro, within three cents of its
record low. The same month, US consumer prices also rose by
the most in 17 years, surging 5.6% from a year earlier.

History Lesson

There can certainly be a very positive circular
feedback loop, said Alan Ruskin, the New York-based
global head of Group of 10 foreign-exchange at Deutsche Bank,
the worlds largest currency trader.

This year, the dollar is forecast to appreciate to $1.28 per
euro from a current $1.3530 and to 110 yen from 104.72,
according to Bloomberg surveys.

The US has pursued energy self-sufficiency ever since Arab
producers declared an oil embargo in the autumn of 1973 to
retaliate against the US government for assisting Israel
during the Yom Kippur War.

The energy crisis caused chronic fuel shortages in the US
that ignited inflation and pushed the economy into a
recession, becoming a precursor to a phenomenon known as
stagflation, which emerged later in the decade.

The nations costs soared as investors demanded more
compensation to hold US government debt, with yields on
10-year Treasuries eclipsing 8% in 1974. An inflation rate of
12.34% that year meant that holders of Treasuries were left
with a loss of about 5.3% in real terms, according to data
compiled by Barclays Plc.

Now, the US is on the verge of surpassing Russia and Saudi
Arabia as the worlds largest producer of oil, according
to the International Energy Agency.

You deserve a stronger currency, stronger financial
markets, a better role within the global financial system
because you are not dependent on imported oil,
Brandywines McIntyre said.

Have your say

All comments are subject to editorial review.
All fields are compulsory.